For too long, China’s interest rates have been kept far below the nation’s nominal GDP growth rate. They are now rising as authorities move to reduce financial repression. The rise in domestic bond yields since June this year points to the market’s demand for higher yields commensurate with the increased systemic risk stemming from shadow banking activities and local government debt.
The People’s Bank of China (PBoC) has shifted to a new paradigm of market-oriented policy to facilitate Beijing’s structural reform efforts. Arguably, the rise in Chinese bonds yields reflects China’s monetary policy rebalancing from central control to market forces.
The rise in China’s bond yields since June this year to nearly a 9-year high is not a sign of savings shortage. Neither is it much related to rising US bond yields, as some analysts have speculated. Ten-year Chinese government bond yield, for example, has had a low correlation coefficient of 0.13 with the 10-year US Treasury yield over the past five years.
Meanwhile, China’s corporate bond yields have mirrored domestic liquidity stress (with a correlation of 0.75), which can be approximated by the fluctuation in China’s Bank Acceptance bill yield. This suggests that the recent rise in yields has been a response to both a tight liquidity environment and the market’s demand for higher returns commensurate with higher systemic risk.
But why is bond market liquidity tight when there are hot money inflows?
First, there has been massive bond selling by domestic financial institutions to raise cash in the face of dwindling domestic demand.
Second, hot money flows are almost irrelevant. The best way to think about this is to use the “disjoint set” concept of probability theory.
Hot money inflows is one set, and it does not intersect with the other set, the domestic bond market. In fact, very little hot money enters the bond market. (Note: overall foreign participation in the onshore bond market is limited to investment quotas, which are a tiny drop in China’s 29.4 trillion yuan domestic bond market capitalization).
Fundamentally, the PBoC has shifted to a more hands-off approach relative to the past, letting the market decide the level of yields. The aim is to constrain economic growth at moderate annual rates between 7 and 8 percent in the medium term to facilitate structural reforms. This policy shift can be seen in the sharp reduction in the PBoC’s repo trades (which are an indicator of monetary expansion) in its open market operations this year.
In response to tight liquidity, domestic financial institutions have sold bonds to raise cash. These bond sales are also part of their preparation for further regulatory tightening on banking and bank-investment operations via the shadow banking market.
However, domestic bond demand has waned due to fierce competition from shadow banking products, which offer much higher returns. This can be seen in the sharp drop in inter-bank bond trading volume to only 1.7 trillion yuan in November from a peak of 8.3 trillion yuan in March and 7.1 trillion yuan a year earlier.
Thriving shadow banking activities without proper regulation gives the PBoC a solid reason to pursue a conservative policy stance to rein in leveraging in the system. The shadow banking market has accounted for the bulk of liquidity growth, as summarized by the total social financing (TSF) flows, since 2009.
After a brief slowdown due to the PBoC’s crackdown in June this year, shadow banking activities have revived, boosting TSF flows while bank credit flows have remained subdued (see chart).
While the shadow banking market helps China to eschew financial repression by providing non-bank financing at market interest rates to the private sector which has little access to bank credit, it is poorly regulated and the non-bank financing framework is still immature.
Its activities not only frustrate the PBoC’s monetary policy but also increase systemic risk due to the lack of regulations and transparency. The higher yields of the shadow banking products have put upward pressure on bond yields, and they suggest that the market is trying to price in higher systemic risk.
The market may also be trying to price in the potential risk of local government debt (LGD), which could hit bank capital ratios badly. The National Audit Office conducted a comprehensive audit on local government finances between June and July this year.
It was supposed to release the report in October, but has yet to do so. According to our estimate, if the LGD has risen to 20 trillion yuan from 10.7 trillion yuan in 2010, average Tier 1 capital in the Chinese banking sector would have dropped to 4.5 percent of risk-weighted assets from 10.5 percent now.
With administrative controls becoming ineffective as a monetary management tool, the recent rise in Chinese bond yields shows that the PBoC is trying to shift to a new paradigm involving market forces. Such a policy shift is consistent with Beijing’s structural reform blueprint, which has elevated the role of the market in the Chinese economy to “decisive” from “basic”.
However, this new monetary policy paradigm also gives the PBoC new challenges. It will have to come up with a new benchmark for anchoring its policy stance. It has not, in my view, decided yet on what indicators to use.
It is still in trial-and-error mode in this policy rebalancing act, which will create market volatility from time to time. The interbank offered rate may be a strong candidate to be the new monetary transmission indicator due to its market-driven characteristic.
There may have been an upward shift in the term structure of China’s interest rates, as the country strives to reduce financial repression and moves towards a market-oriented growth model. The market will have to live with structurally higher interest rates in the future, but for good reasons.